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The second evaluation we can use is that of the liquidity trap. Let’s
bring up your money supply and demand graph here. Notice this flat
portion. The idea is that even though people demand money for two
reasons, transaction and assets but there is a fixed amount that people
will need no matter what. This is the transaction amount. Hence, it is
the asset one that varies at least to a plateau in the region on the
right. even if we increase money supply all the way to the
right, people will still need money for transaction even though they may
not desire it as an asset. So, this sets a lower maximum for the interest
rate. Interest rates cannot possibly go lower than this. What then happens
is that if you try to do expansionary monetary policy, the interest rate
won’t budge at all. As the interest doesn’t budge, you are handicapped.
There is nothing you can do to affect the AD if your interest rate doesn’t
move. We call this regional liquidity trap because it is trap that renders
interest rate policy useless. It limits the effectiveness of expansionary
monetary policy.